I'm willing to take this before the 19th of may.

PROFESSIONAL ISSUES When a company looks too good to be true, it usually is. ; i - I The Rise and Fall of Enron BY C. WILLIAM THOMAS f you''re like most, you've been astonished, disillusioned and angered as you learned of the meteoric rise and fall of Enron Corp. Remember the company's television commercial of not so long ago, ending with the reverberating phrase, "Ask why, why, why?" That question is now on everyone's lips. The Enron case is a dream for academics who conduct research and teach. For those currently or formerly involved with the company, such as creditors, auditors, the SEC and accounting regulators, it's a nightmare that will continue for a long time. Formal investigations of Enron are now under way, headed hy the company's hoard, the SEC, the Justice Department and Congress. The exact causes and details of the disaster may not be known for months. The purpose of this article is to summarize preliminary observations about the collapse, as well as changes in financial reporting, auditing and corporate governance that are being proposed in response by Big Five accounting firms, the AICPA and the SEC. IN A WAY IT'S SIMPLE, IN A WAY IT'S NOT On the surface, the motives and attitudes behind decisions and events leading to Enron's eventual downfall appear simple enough: individual and collective greed horn in an atmosphere of market euphoria and corporate arrogance. Hardly anyone the company, its employees, analysts or individual investors- wanted to heheve the company was too good to be true. So, for a while, hardly anyone did. Many kept on buying the stock, the corporate mantra and the dream. In the meantime, the company made many high-risk deals, some of which were outside the company's t>'pical asset risk control process. Many went sour in the early months of 2001 as Enron's stock price and debt rating imploded because of loss of investor and creditor trust. Methods the company used to disclose (or creatively obscure) its comphcated financial dealings were erroneous and, in the view of some, downright deceptive. The company's lack of transparency in reporting its financial affairs, followed by financial restatements disclosing billions of dollars of oinitted Habihties and losses, contributed to its demise. The whole affair happened under the watchful eye of Arthur Andersen LLP, which kept a whole floor of auditors assigned at Enron year-round. THE BEGINNING PRESAGES THE END In 1985, after federal deregulation of natural gas pipelines, Enron was horn from the merger of Houston Natural Gas and InterNorth, a Nebraska pipeline company. In the process of the merger, Enron incurred massive deht and, as the result of deregulation, no longer had exclusive rights to its pipelines. In order to survive, the company had to come up with a new and innovative business strategy to generate profits and cash flow. Kenneth Lay, CEO, hired McKinsey & Co. to assist in developing Enron's business strategy. It assigned a young consultant named Jeffrey SkiUing to the engagement. Skilling, who had a hackground in banking and asset and liability management, proposed a revolutionary solution to Enron's credit, cash and profit woes in the gas pipeline business: create a "gas bank" in which Enron would buy gas from a network of suppliers and sell it to a network of consumers, contractually guaranteeing both the supply and the price, charging fees for the transactions and assuming the associated risks. Thanks to the young consultant, the company created both a new product and a new paradigm for the industrythe energy derivative. (continued on page 42} A p r i l 2OU2 JOURNAL D / A CCOUNTANCY 41 PROFESSIONAL ISSUES its history. Enron's corporate leadership. Lay excluded, comprised mostly young people who had never experienced an extended bear market. New investment opportunities were opening up everywhere, including markets in energy futures. Wall Street demanded double-digit growth from practically every venture, and Enron was determined to deliver. In 1996 Skilling became Enron's chief operating officer. He convinced Lay the gas bank model could be apphed to the market for electric energy as well. Skilling and THE BEST, THE BRIGHTEST AND THE Lay traveled widely across the country, DREADED PRC selling the concept to the heads of power Skiiling instituted Skilling began to change the corporate companies and to energy regulators. The culture of Enron to match the company's the PRC, which company became a major political player transformed image as a trading business. in the United States, lobbying for deregubecame known as the He set out on a quest to hire the best and lation of electric utilities. In 1997 Enron brightest traders, recruiting associates fix)m harshest employeeacquired electric utility company Portland the top MBA schools in the country and General Electric Corp. for about $2 bilranking system in competing with the largest and most preslion. By the end of that year, Skilling had tigious investment banks for talent. In exthe country. developed the division by then known as change for grueling schedules, Enron Enron Capital and Trade Resources into pampered its associates with a long list of the nation's largest wholesale buyer and seller of natural gas corporate perks, including concierge services and a company and electricity. Revenue grew to $7 billion from $2 billion, gym. SkiUing rewarded production with merit-based bonuses and the number of employees in the division skyrocketed to that had no cap, permitting traders to "eat what they killed." more than 2,000 from 200. Using the same concept that had One of Skilling's eadiest hires in 1990 was Andrew Eastow, been so successful with the gas bank, they were ready to create a 29-year-old Kellogg MBA who had been working on lever- a market for anything that anyone was willing to trade: fiatures aged buyouts and other complicated deals at Continental Illi- contracts in coal, paper, steel, water and even weather. nois Bank in Chicago. Fastow hecame Skilling's protege in the same way Skilhng had become Lay's. Fastow moved swiftly Perhaps Enron's most exciting development in the eyes of through the ranks and was promoted to chief financial officer the financial world was the creation of Enron Online (EOL) in 1998. As Skilling oversaw the building of the company's in Octoher 1999. EOL, an electronic commodities trading vast trading operation, Fastow oversaw its financing hy ever Web site, was significant for at least two reasons. First, Enron more complicated means. was a counterparty to every transaction conducted on the As Enron's reputation with the outside world grew, the inter- platform. Traders received extremely valuable information renal culture apparently began to take a darker tone. Skilling insti- garding the "long" and "short" parties to each trade as well as tuted the performance review committee (PRC), which hecame the products' prices in real-time. Second, given that Enron knovm as the harshest employee-rankir^ system in the country It was either a buyer or a seller in every transaction, credit risk was known as the "360-degree review" based on the values of management was crucial and Enron's credit was the cornerEnronrespect, integrity, communication and excellence stone that gave the energy community the confidence that (RICE). However, associates came to feel that the only real per- EOL provided a safe transaction environment. EOL became formance measure was the amount of profits they could produce. an overnight success, handling $335 hillion in online comIn order to achieve top ratings, everyone in the organization he- modity trades in 2000. came instantly motivated to "do deals" and post earnings. EmThe world of technology opened up the Internet, and ployees were regularly rated on a scale of 1 to 5, with 5s usually the IPO market for technology and broadband communicabeing fired within six months. The lower an employee's PRC tions companies started to take off. In January 2000 Enron score, the closer he or she got to Skilling, and the higher the announced an ambitious plan to build a high-speed broadscore, the closer he or she got to being shown the door. Skilling's band telecommunications network and to trade network cadivision was known for replacing up to 15% of its workforce pacity, or bandwidth, in the same way it traded electricity or every year. Fierce internal competition prevailed and immediate natural gas. In July of that year Enron and Blockbuster angratification was prized above long-term potential. Paranoia flour- nounced a deal to provide video on demand to customers ished and trading contracts began to contain highly restrictive throughout the world via high-speed Internet lines. As Enconfidentiality clauses. Secrecy became the order of the day for ron poured hundreds of millions into hroadband with very many of the company's trading contracts, as well as its disclosures. little return. Wall Street rewarded the strategy with as much as $40 on the stock pricea factor that would have to be discounted later when the broadband bubble burst. In AuHOW HIGH THEY FLY gust 2000 Enron's stock hit an all-time high of $90.56, and Coincidentally, but not inconsequentially, the U.S. economy during the 1990s was experiencing the longest bull market in the company was being touted by Fortune and other business Lay was so impressed with Skilling's genius that he created a new division in 1990 called Enron Finance Corp. and hired Skilling to run it. Under SkUHng's leadership, Enron Finance Corp. soon dominated the market for natural gas contracts, with more contacts, more access to supplies and more customers than any of its competitors. With its market power, Enron could predict future prices with great accuracy, thereby guaranteeing superior profits. 42 JOURNAL ../ACCOUNTANCY April 2002 PROFESSIONAL ISSUES publications as one of the most admired and innovative companies in the world. j THE ROLE OF MARK TO-MARKET ACCOUNTING Enron incorporated "mark-to-market accounting" for the energy trading husiness in the mid-1990s and used it on an unprecedented scale for its trading transactions. Under mark-to-market rules, whenever companies have outstanding energy-related or other derivative contracts (either assets or liahilities) on their balance sheets at the end of a particular quarter, they must adjust them to fair market value, booking unrealized gains or losses to the income statement of the period. A difficulty with application of these rules in accounting for long-term futures contracts in commodities such as gas is that there are often no quoted prices upon which to hase valuations. Companies having these t^'pes of derivative instruments are free to develop and use discretionary valuation models based on their own assumptions and methods. The Financial Accounting Standards Board's (FASB) emerging issues task force has debated the suhject of how to value and disclose energy-related contracts for several years. It has been able to conclude only that a one-size-fits-all approach will not work and that to require companies to disclose all of the assumptions and estimates underlying earnings would produce disclosures that were so voluminous they would be of little value. For a company such as Enron, under continuous pressure to beat earnings estimates, it is possible that valuation estimates might have considerably overstated earnings. Furthermore, unrealized trading gains accounted for slightly more than half of the company's $1.41 billion reported pretax profit for 2000 and about one-third of its reported pretax profit for 1999. CAPITALISM AT WORK In the latter part of the 1990s, companies such as Dynegy, Duke Energy, El Paso and Williams began following Enron's lead. Enron's competitive advantage, as well as its huge profit margins, had begun to erode by the end of 2000. Each new market entrant's successes squeezed Enron's profit margins further. It ran vv-ith increasing leverage, thus becoming more like a hedge fund than a trading company. Meanwhile, energ)' prices began to fall in thefirstquarter of 2001 and the world economy headed into a recession, thus dampening energy market volatility' and reducing the opportunity for the large, rapid trading gains that had formerly made Enron so profitable. Deals, especially in the finance division, were done at a rapid pace without much regard to whether diey aligned with the strategic goals of the company or whether they complied with the company's risk management policies. As one knowledgeable Enron employee put it: "Good deal vs. bad deal? Didn't matter. If it had a positive net present value (NPV) it could get done. Sometimes positive NPV didn't even matter in the name of strategic significance." Enron's foundations were developing cracks and Skilling's house of paper built on the stilts of trust had begun to crumble. RELATED PARTIES AND COMPLEX SPECIAL PURPOSE ENTITIES In order to satisfy Moody's and Standard & Poor's credit rating agencies, Enron had to make sure the company's leverage ratios were within acceptable ranges. Fastow continually lobbied the ratings agencies to raise Enron's credit rating, apparently to no avail. That notwithstanding, there were other ways to lower die company's debt ratio. Reducing hard assets while earning increasing paper profits served to increase Enron's return on assets (ROA) and reduce its debt-to-total-assets ratio, making the company more attracdve to credit rating agencies and investors. Enron, like many other companies, used "special purpose entities" (SPEs) to access capital or hedge risk. By using SPEs such as limited partnerships with outside parties, a company is permitted to increase leverage and ROA without having to report deht on its balance sheet. The company contributes hard assets and related debt to an SPE in exchange for an interest. The SPE then horrows large sums of money from a financial institution to purchase assets or conduct other business without the deht or assets showing up on the company's financial statements. The company can also sell leveraged assets to the SPE and hook a profit. To avoid classification of the SPE as a subsidiary (thereby forcing the entit}' to include the SPE's financial position and results of operations in its financial statements), FASB guidelines require that only 3% of the SPE be owned by an outside investor. Under Fastow's leadership, Enron took the use of SPEs to new heights of complexity and sophistication, capitalizing theni with not only a variety of hard assets and hahilities, but also extremely complex derivative financial instruments, its own restricted stock, rights to acquire its stock and related habilities. As its financial dealings became more complicated, the company apparently also used SPEs to "park" troubled assets that were falling in value, such as certain overseas energy facilities, the broadband operation or stock in companies that had been spun off to the public. Transferring these assets to SPEs meant their losses would be kept off Enron's books. To compensate partnership investors for downside risk, Enron promised issuance of additional shares of its stock. As the value of the assets in these partnerships fell, Enron began to incur larger and larger obligations to issue its own stock later down the road. Compounding the problem toward the end was the precipitous fall in the value of Enron stock. Enron conducted business through thousands of SPEs. The most controversial of them were LJM Cayman LP and LJM2 Co-Investment LP, run by Fastow himself. From 1999 through July 2001, these entities paid Fastow more than $30 million in management fees, far more than his Enron salary, supposedly with the approval of top management and Enron's hoard of directors. In turn, the LJM partnerships invested in another group of SPEs, known as the Riptor vehicles, which were designed in part to hedge an Enron investment in a bankrupt broadband company. Rhythm NetConnections. As part of the capitalization of the P^ptor entities, Enron issued common stock in exchange for a note receivable of $1.2 billion. Enron increased notes receivable and shareholders' equity to reflect this transaction, which appears to violate generally accepted accounting principles. Additionally, Enron failed to consolidate the LJM and P^ptor SPEs into their financial statements when subsequent information revealed they should have been consolidated. OBSCURE DISCLOSURES REVEALED A very confusing footnote in Enron's 2000 financial statements described the above transactions. Douglas Carmichael, the April 2002 JOURNAL w / A C C O U N l ANCY 43 PROFESSIONAL ISSUES of&et the company's private equity losses, severely diWollman Distinguished Professor of Accounting at luting earnings. It also disclosed the reversal of the Baruch College in New York City, told the Wall $1.2 billion entry to assets and equities it had Street Journal in November of 2001 that most peomade as a result of dealings with these ple would be hard pressed to understand the efarrangements. It was this disclosure that got fects of these disclosures on the financial the SEC's attention. statements, casting doubt on both the quality On Octoher 17 the company announced of the company's earnings as well as the busiit had changed plan administrators for its emness purpose of the transaction. By April ployees' 401 (k) pension plan, thus hy law lock2001 other skeptics arrived on the scene. A ing their investments for a period of 30 number of analysts questioned the lack of days and preventing workers from selling transparency of Enron's disclosures. One their Enron stock. The company conanalyst was quoted as saying, "The notes tends this decision had in fact been made just don't make sense, and we read notes months earlier. However true that might for a living." Skilling was very quick to reSenior management be, the timing of the decision certainly ply with arrogant comments and, in one continued to exit, has raised suspicions. case, even called an analyst a derogatory coliectively hundreds On October 22 Enron announced the name. What Skilling and Fastow apparSEC was looking into the related party ently underestimated was that, because of of millions of dollars transactions between Enron and the partsuch actions, the market was beginning to richer for the nerships owned by Fastow, who was fired perceive the company with greater and two days later. On Novemher 8 Enron greater skepticism, thus eroding its trust experience. announced a restatement of its financial and the company's reputation. statements back to 1997 to reflect consolidation of the SPEs it had omitted, as well as to hook AnderIT ALL COMES TUMBLING DOWN In Fehruary 2001 Lay announced his retirement and named sen's recommended adjustments from those years, which the SkiUing president and CEO of Enron. In Fehruary Skilling company had previously "deemed immaterial." This restateheld the company's annual conference with analysts, bragging ment resulted in another $591 million in losses over the four that the stock (then valued around $80) should be trading at years as well as an additional $628 million in liabilities as of the around $126 per share. end of 2000. The equity markets immediately reacted to the In March Enron and Blockbuster announced the cancella- restatement, driving the stock price to less than $10 a share. tion of their video-on-demand deal. By that time the stock One analyst's report stated the company had burned through had fallen to the mid-$60s. Throughout the spring and sum- $5 hillion in cash in 50 days. mer, risky deals Enron had made in underperforming investA merger agreement with smaller cross-town competitor ments of various kinds began to unravel, causing it to suffer a Dynegy was announced on Novemher 9, hut rescinded by huge cash shortfall. Senior management, which had heen vot- Dynegy on November 28 on the basis of Enron's lack of full ing with its feet since August 2000, selling Enron stock in the disclosure of its off-balance-sheet debt, downgrading Enron's bull market, continued to exit, collectively hundreds of mil- rating to junk status. On Novemher 30 the stock closed at an hons of dollars richer for the experience. On August 14, just astonishing 26 cents a share. The company filed for bankruptsix months after being named CEO, Skilling himself resigned, cy protection on December 2. citing "personal reasons." The stock price slipped below $40 that week and, except for a brief recovery in early October af- THE AFTERMATH ter the sale of Portland General, continued its slide to helow Unquestionahly, the Enron implosion has wreaked more havoc $30 a share. on the accounting profession than any other case in U.S. histoAlso in August, in an internal memorandum to Lay, a com- ry. Critics in the media. Congress and elsewhere are calling pany vice-president, Sherron Watkins, described her reserva- into question not otily the adequacy of U.S. disclosure practices tions about the lack of disclosure of the substance of the hut also the integrity of the independent audit process. The related party transactions with the SPEs run by Fastow. She general public still questions how CPAfirmscan maintain audit concluded the memo by stating her fear that the company independence while at the same time engaging in consulting might "implode under a series of accounting scandals." Lay work, often for fees that dwarf those of the audit. Companies notified the company's attorneys, Vinson & Elkins, as well as that deal in special purpose entities and complex financial inthe audit partner at Enron's auditing firm, Arthur Andersen struments similar to Enron's have suffered significant declines in LLP, so the matter could be investigated further. The prover- their stock prices. The scandal threatens to undermine confibial "ship" of Enron had struck the iceberg that would even- dence infinancialmarkets in the United States and abroad. tually sink it. In a characteristic move, the SEC and the public accountOn October 16 Enron announced its first quarterly loss in ing professioti have been among the first to respond to the Enmore than four years after taking charges of $1 billion on ron crisis. Unfortunately, and sadly reminiscent of financial poorly performing businesses. The company terminated the disasters in the 1970s and 1980s, this response will likely be Raptor hedging arrangements which, if they had continued, viewed by investors, creditors, lawmakers and employees of would have resulted in its issuing 58 million Enron shares to Enron as "too little, too late." 44 JOURNAL o/ A C C O U N T A N C Y April 2002 PROFESSIONAL ISSUES In an "op-ed" piece for tbe Wall Street Journal on Dccetnber 11, SEC Cbairman Harvey Pitt called tbe current outdated reporting and financial disclosure system the financial "perfect storm." He stated that under tbe current quarterly and annual reporting system, information is often stale on arrival and mandated financial disclosures are often "arcane and impenetrable." To reassure investors and restore confidence in financial reporting, Pitt called for a joint response from tbe public and private sectors that included, among other things, In late December the AICPA issued a tool kit for auditors to use in identifying and auditing related party transactions. While it breaks no new ground, the tool kit provides, in one place, an overview of the accounting and auditing literature, SEC requirements and best practice guidance concerning related party transactions. It also includes checklists and other tools for auditors to use in gathering evidence and disclosing related party transactions. In January the AICPA board of directors announced tbat it would cooperate A system of "current" disclosures, fully with the SECs proposal for new supplementing and updating quarterly and rules for the peer review and disciplinary The AICPA has been annual information with disclosure of maprocess for CPA firms of SEC registrants. engaged in significant terial information on a real-time basis. The new system would be managed by a damage control Public company disclosure of signifiboard, a inajority of which would be cant current "trend" and "evaluative" data public members, enbancing tbe peer remeasures to restore in addition to bistorical information. view process for tbe largest firms and reconfidence in the ti Identification of "most critical acquiring more rigorous and continuous coutiting principles" by all pubUc compamonitoring. Tbe staff of tbe new board profession. tiies in their annual reports. would administer tbe reviews. In protest, More timely aiid responsive accountthe Public Oversight Board informed Pitt ing standard setting on the part of the private sector. that it would terminate its existence in March 2002, leaving An environment of cooperation between tbe SEC and the future peer review process in a state of uncertainty. The registrants that encourages public companies and their auditors SEC and the AICPA are now engaged in talks with tbe POB to seek advice on disclosure issues in advance. to reassure tbe board it wiU continue to be a vital part of tbe An effective and transparent system of self-reguiatioti for peer review process in the future. tbe accounting profession, subject to SECs rigorous, but The AICPA bas also approved a resolution to support pronondupHcative, oversigbt. hibitions tbat would prevent audit firms from performing sys More proactive oversigbt by audit committees who un- tems design and implementation as well as internal audit derstand financial accounting principles as weU as how they are outsourcing for public audit clients. Wbile asserting tbat it apphed. does not believe prohibition of these services will make audits The CEOs of tbe Big Five accounting firms made a j oint more effective or prevent financial failures, the board bas stated statement on December 4 committing to develop improved it feels tbe move is necessary to restore public confidence in guidance on disclosure of related party transactions, SPEs and tbe profession. These prohibitions were at the center of the market risks for derivatives including energy contracts for tbe controversy last year between the profession and the SEC un2001 reporting period. In addition, tbe Big Five called for der the direction of former Chairman Arthur Levitt. Big Five modernization of tbe financial reporting system in the United CPA firtns and the AICPA lobbied heavily and prevailed in States to make it more timely and relevant, including more that controversy, winning tbe right to retain tbese services and nonfmancial information on entity performance. They also being required only to disclose their fees. vowed to streamline the accountitig standard-setting process to Tbe impact of Enron is now being felt at the highest levels make it more responsive to the rapid changes that occur in a of government as legislators engage in endless debate and actechnology-driven economy. cusation, quarreling over the influence of money in politics. Since the Enron debacle, tbe AICPA bas been engaged in The GAO bas requested tbat the White House disclose docusignificant damage control measures to restore confidence in tnents concerning appointments to President George W tbe profession, displaying tbe banner "Enron: Tbe AICPA, Bush's Task Force on Energy, chaired by Vice-President Dick tbe Profession, and tbe Public Interest" on its Web site. It has Cheney, former CEO of Halliburton. The White House has announced the imminent issuance of an exposure draft on a refused, and the GAO has filed suit, tbe first of its kind in hisnew audit standard on fraud (the third in five years), provid- tory. Congressional investigations are expected to continue ing more specific guidance than currently found in SAS no. well into 2002 and beyond. Lavv'niakers are expected to inves82, Consideration of Fraud in a Financial Statement Audit. T he tigate not only disclosure practices at Enron, but for all public Institute has also protnised a revised standard on reviews of companies, concernitig SPEs, related party transactions and quarterly financial statements, as w-ell as the issuatice, in tbe use of "mark-to-niarket" accounting. second quarter of 2002, of an exposure draft of a standard to Kenneth Lay resigned as Enron's CEO, under pressure improve tbe audit process. These standards had already been from creditor groups. Lay, Skilling and Fastovi^ still have much on the drawing board as part of tbe AlCPA's response to tbe to explain. In addition, Enron's board of directors, and espereport of tbe Blue Ribbon Panel on Audit EfTectiveness, iscially tbe audit committee, will be in tbe "hot seat" and sued in 2000. rigbtfijlly so. (continmd on pa^e 47) A p r i l 2(J02 . J OURNAL 0 / A CCOUNTANCY 45 PROFESSIONAL ISSUES The Justice Department opened a criminal investitbe firm's document retention and destruction poUgation and formed a national task force made up of cies. The firm fired David B. Duncan, parttier iti federal prosecutors in Houston, San Francisco, charge of the Enron cngagemetit, placed four New York and several other cities to investigate other partners on leave and replaced tbe the possibility of fi"aud in tbe company's dealentire management team of tbe Houston ings. Interestingly, to illustrate bow far-reachoffice. Duncan invoked his Eifth Amending Enron's ties are to government and ment rights against self-incrimination at a political sources at all levels, US. Attorney congressional hearing in January. Several other General John Asbcroft, as well as his entire Andersen partners testified that Duncan and his Houston office, disqualified thctnselves staff acted in violation of firm policy. from the investigation because of eitber However, in view of the timing of the political, economic or family ties. October 12 memorandum. Congress and the press are questioning whether the deIt appears tbat 2002 is shaping up to be cision to shred documents extended fara year of unprecedented cbanges for .1 Some of the classic ther up the chaiti of command. Andersen profession that is already coping with an risk factors associated has suspended its firm policy for retenidentity crisis. tion of records and asked former U.S. with management Senator Jobti Danfortb to conduct a WHERE WERE THE AUDITORS? fraud outiined in SAS comprehensive review of the firm's Arthur Andersen LLP, after settling two no. 82 are evident in records management policy and to recother massive lawsuits earlier in 2001, is ommend improvements. preparing for a storm of Utigation as well the Enron case. as a possible criminal investigation in the In a move to bolster its image, Anderwake of tbe Enron collapse. Enron was sen also bas retained former Federal Retbe firm's second-largest client. Anderseti, who had the job serve Chairman Paul Volcker to lead an outside board that not only of Enron's external but also its internal autlits for the will advise it in making "fundamental change" iti its audit years in question, kept a staff on permanent assigtiment at process. Other members of the board include P. Roy Vagelos, Enron's offices. Many of Enron's internal accountants, CFOs former cbairman and CEO of Merck & Co., and Cbarles A. and controUers were former Andersen executives. Because of Bowsher, current chairman of the Public Oversight Board, these relationships, as weU as Andersen's extensive concurrent which disbanded iti March. Volcker also tianied a sevenconsulting practice, members of Congress, tbe press and oth- member advisory panel made up of prominent corporate and ers are calling Andersen's audit independence into question. accounting executives that will review proposed reforms to Indeed, they are using tbe case to raise doubts about the tbe firm's audit process. credibility of the audit process for al! Big Five firms who do Hincisight is so clear that it sometimes belies the complexity such work. of the problem. Altbough fraud bas not yet been proven to be So far, Andersen bas acknowledged its role in tbe fiasco, a factor in Enron's misstatetnents, some of tbe classic risk facwhile defending its accounting and audititig practices. In a tors associated with managementfiraudoutlined in SAS no. 82 Wall Street Journal editorial on December 4, as well as in testi- are evident in the Etiroti case. Those include management mony before Congress tbe following week, Josepb Berardino, characteristics, industry conditions and operating cbaracterisCEO, was forthright in his views. He committed the firm to tics of tbe company. Altbougb written five years ago, tbe list fuU cooperation in the investigations as well as to a leadership almost looks as if it was excerpted from Enron's case: role in potential solutions. Unduly aggressive earnings targets and management Enron dismissed Andersen as its auditor on January 17, bonus compensation based on tbose targets. 2002, citing document destruction and lack of guidance on Excessive interest by management in maintaining stock accounting policy issues as tbe reasons. Andersen countered price or earnings trend tbrougb tbe use of unusually aggressive witb tbe contention tbat in its mind tbe relationship bad ter- accounting practices. minated on December 2, 2001, the day the firm filed for Management setting unduly aggressive financial targets Chapter II bankruptcy protection. and expectations for operating personnel. The fact that Andersen is no longer officially associated Inability to generate sufficient cash flow frotn operations with Enron will, unfortunately, have little impact on forces wliile reporting earnings and earnings growth. now in place tbat may, in tbe eyes of some, determine tbe Assets, liabilities, revenues or expenses based on signififirm's very future. Anderseti is novt' under formal investiga- cant estimates that involve unusually subjective judgments sucb tion by tbe SEC as well as various committees of both the as.. .reliability offinancialinstruments. U.S. Setiate and House of Representatives of the U.S. Coti Significant related party transactions. gress. To make tiiatters worse for it, and to the astonishment Tbese factors are cotiimon threads in the tapestry that is of many, Andersen admitted it destroyed perhaps thousands of described of tbe environment leading to fraud. They were documents and electronic files related to tbe engagement, in incorporated into SAS no. 82 oti the basis of research into accordance with "firm policy," supposedly before the SEC is- fraud cases of the 1970s and 1980s in the hope that auditors sued a subpoena for them. The firm's lawT,'ers issued an inter- would learn from the past. Andersen will have to explain nal memorandum on October 12 retninding employees of when and bow it identified these factors, as well as how it reApril 2002 JOURNAL 0/ ACCOUNTANCY 47 PROFESSIONAL ISSUES sponded and how it communicated with Enron's board about them. More important, Andersen will have to explain why it delayed notifying the SEC after learning of the internal Enron memo warning of problems. In addition, it will bave to explain why the Houston office destroyed the thousands of documents related to the Enron audits for 1997 through 2000. Only time wiU tell, but it appears the firm is in serious trouble. In the end, and also characteristic of cases like this, the chief parties likely to benefit from this process are the attorneys. THE HUMAN FACTOR The Enron story has produced many victims, tbe most tragic of which is a former vice-chairman of the company who committed suicide, apparently in cotinection witb bis role in the scandal Another 4,500 individuals have seen their careers ended abruptly by tbe reckless acts of a few. Enron's core values of respect, integrity, communication and excelletice stand in satirical contrast to allegations now being made public. Personally, I bad referred several of our best and brightest accounting, finance and MBA graduates to Enron, hoping they could gain valuable experience from seeing things done right. These in- cluded a very bright training consultant who had lost her job in 2000 witb a Houston consulting firm as a result of a reduction in force. She has lost ber secondjob in \\S n iontbs tbrougb no fault of her own. Other former students still hanging on at Enron face an tmcertain fijture as the company fights for survival. The old saying goes, "Lessons learned hard are learned best." Some former Enron employees are embittered by the way they have been treated by tbe company that was once "the best in tbe business." Otbers disagree. In the words of one of my former students who is still hanging on: "Just for the record, my time and experience at Enron have been nothing short of fantastic. I could not bave asked for a better place to be or better people to work with. Please, though, remetnber this: Never take customer and employee confidence for granted. Tbat confidence is easy to lose and toughto impossibleto regain." C. WILLIAM THOMAS, CPA, PbD, is the J.E. Busb Professor of Accounting in tbe Hankaiiier School of Business at Baylor University in Waco. Mr. Thomas can be reached at BiIl_Thomas@ baylor.edu. This article originally appeared in the March/April 2002 issue of Today's CPA, published by the Texas Society of CPAs. Eichwald, Kurt (New York Times), Lee, Susan. "The Dismal Science: En"Exec Abuses Criticized in Enron Re- ron's Success Story." Wall Street Journal. "A Chronology of Enron's Recent port." Waco Tribune-Herald. February 3, December26, 2001: A l l . Woes." Wall Street Jotirnal, December 20, 2002. Oppel, Pdchard A. Jr. and Stephen 2001. Etnshwiller, John R. and Rebecca Labaton. "Enron Hearings Open, Focus "Accounting and Auditing for P^lated Smith. "Corporate VeilBehind En- ing on Destroyed Papers." New York Parties and Related Party Transactions: A ron's FaU, A Culture of Operating Out- Ti'mcf. January 25, 2002. Toolkit for Accountants and Auditors." side Public's View." Wall Street Journal. Pitt, Harvey L. "How to Prevent FuDecember5, 2001: Al. www.alcpa.org. ture Enrons." Wall Street Journal, Decem "AICPA Statement of James G. 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Janu- tion About Related Party and Off-Bal- Wall Street journal. N ovember 2, ance Sheet Transactions; Company to 2001 :A1. ary 30, 2002. Berger, Eric. "The Fall of Enron/Like Restate Earnings for 1997-2001." Enron Statement from Big Five CEOs on Enron, PR newswire. Enron Employees, Lay Could Lose press release. November 8, 2001. Nearly All/Vast Fortune from Stocks, Flood, Mary. "Bankruptcy Tip of Ice- Swartz, Mimi. "How Enron Blew It." Bonuses Susceptible to Lav^suits." Hous- berg in Broadening Legal Mess." Houston Texas Monthly. N ovember 2001: 136ton Chronicle. JAnuary 2S, 2002: A 19. Chronicle. December 11, 2001: Business 1. 139, 171-178. Brown, Ken, et al. "Andersen Fires Part- Goldberg, Laura and L.M. Sixel. "En- Taub, Stephen. "Angry Employees ner It Says Led Shredding of Documents." ron on Edge of Collapse/Stock Value Sue Etiron." www.CFO.com. November Wall Street Journal. J^nuarf 16, 2002. Plunges as Dynegy Bails Out; Bankrupt- 26,2001. Browning, E.S. and Jonathan Weil. cy Expected." Houston Chronicle. N o - Weil, Jonathan. "After Enron, 'Mark to Market' Accounting Gets Scrutiny." "Stocks Take a Beating as Accounting vember 29, 2001: AI. Worries Spread Beyond Enron." Wall Grunder, Eric. "Market's BullisbC")r Wall Street Journal. D ecember 4, 2001: CI. Street Journal. Janiuvy 30, 2002. Is It?" 77(6- Record. December 9, 2001. H Clow, Robert. "Enron in Crisis." Fi- Ivanovich, David. "New Twists in En- Weil, Jonathan. "What Enron's Finannancial Times. November 9, 2001: 27. rou Fall: Local Feds, Ashcroft Recused cial Reports Did-^and Didn'tRrveal." "Certified Public Scapegoat." Editori- from Inquiry." Houston Cr/iroiiic/e. January Wall Street Journal, N ovember 5, 2001: CI. al, New York 'Times. j.inuary 2 5, 2 002. 11,2002: Al. Resources 48 JOURNAL ./ACCOUNTANCY April 2002 executive action no. 15 february 2002 The Enron Ethics Breakdown By Ronald E. Berenbeim It is perhaps the most compelling business ethics case in After all, being ethically literate is not just about giving a generationa textbook version of what can go wrong in large sums of money to charitysomething that Enron an organization that lacks a true culture of ethical com- did. It is about recognizing and acting on potential ethi- pliance. Investors and the media once considered Enron cal issues before they become legal problems. Here, to be the company of the future, but as its demise sug- Enron appears to get a failing grade. Now a detailed look gests, it was in reality not a particularly modern business into the ethics breakdown at Enron and what it can organization, especially in its approach to ethics. On the teach companies about the importance of developing an surface, at least, it appeared to reject progressive innova- ethics-based corporate culture. tion in governance and ethics programs and instead sought to circumvent systems that were designed to protect the company and its shareholders. Failure of the Market to Perform and Professional Dilemmas The purpose of this report is not to comment on the In reality, there is nothing wrong with markets failing to legal or political ramifications of the case but rather to fulfill their task of leveling the playing field between focus on the business ethics issues raised by the conduct buyer and seller. Such market failures are in fact how of the company's directors and officers, its accountants, many organizations make their moneythrough patents and lawyers as it is known to date. It is meant to be a (temporary monopolies) and the use of expertise that is reminder that simply having a detailed code of ethics not universally available (competitive advantage). Yet on the books (as Enron certainly did) is not enough. there are certain forms of this type of market failure that Organizations need to infuse ethics and integrity are so egregious that they unreasonably interfere with throughout their corporate culture as well as into their the rights of others and endanger the credibility of all definition of success. legitimate transactions. The most common form of market failure is informa- Truth and Disclosure tion asymmetriesthe business decision-maker knows \"Falsehood ceases to be falsehood, when the truth something that the person at the other end of the transaction does not. Most of the time this is fine but is not expected to be spoken\The Enron Bankruptcy 2001 A Bankruptcy Odyssey 1 Accounting Regulation and Enron 2 What difference a year makes ! $80 $75 12/31/00 12/31/00 2/23/01 July 01 Aug. 01 8/14/01 10/16/01 10/31/01 11/08/01 11/12/01 11/19/01 11/28/01 12/02/01 2/23/01 $50 July 01 $45 August 01 $35 - $25 10/16/01 8/14/01 $15 ---- $5 11/08/01 10/31/01 11/19/01 12 / 02/01 11/12/01 11/28/01 Year-end Management issues annual report with Anderson audit report Federal regulators institute price controls in Western energy markets Jeff Skilling resigns as CEO 2nd Quarter Results (10Q), $ 1.3 Billion cash outflow from operations Mgmt. Announces 3rd quarter loss of $618 Million SEC and Board investigation into related party transactions Enron restates prior year's financial statements and Anderson withdraws prior opinions on '97 thru '00 financial statements Downgrade in credit rating to BBB3rd Quarter 10Q filed with SEC discloses weakened financial condition Dynergy terminates merger discussion - Debt downgraded -- $3.9 Billion in debt comes due Enron files for bankruptcy So what was going on ? Continued decline in profitability (revenues up and net profit margins down) due to absorbing losses from bad investments and ineffective hedges Deposit Activity: Assets: $2.4 to $2.5 B Liabilities: $4.3 to $1.7 B At the end of every quarter operations is using cash flow, not providing cash flow. Enron has reach a limit where banks are no longer willing to continue lending. Enron cannot retire debt as its comes due, it losses its investment grade credit rating, and fails due to liquidity problems 4 Timeline - what was there at Dec 31st 2000 or at least Feb 23rd 2001 12/31/00 2/23/01 12 / 02/01 12/31/00 Year-end 2/23/01 Management issues annual report with Anderson audit report Significant revenues growth ($40 Billion to $100 Billion) Profitability declines (net income as a % of sales goes from 2.2% to 1% Enron is more heavily leveraged and more heavily dependent upon lenders (debt to equity goes from 2.49 : 1 to 4:71 : 1) 52% of Pretax Income is from non-cash sources. Multiple guarantees in footnotes **** An increase in Cash Flow from Operations is driven by one-time transactions **** Can Enron generate cash flows to pay approx. $2.8 Billion in debt? 5 More Clues from the numbers 8/14/01 12/31/00 2/23/01 5/15/01 July 01 August 01 10/31/01 10/16/01 12 / 02/01 12/31/00 Year-end 2/23/01 Management issues annual report with Anderson audit report 5/15/01 First Quarter 10Q: $464 Million Cash outflow from Operations Net Borrowing of $1.5 Billion Aug. 01 Jeff Skilling resigns as CEO 8/14/01 2nd Quarter UNAUDITED Results (10Q), $ 1.3 Billion cash outflow from operations 10/16/01 Mgmt. Announces 3rd quarter loss of $618 Million 6 Q1 Restatement of Financial Statements Already highly leveraged debt to equity goes from 4.7: 1 to 5.3: 1 at 12/31/00 Before Assets $65,503 Debt $54,033 Equity $11,470 Net Income $ 979 After $64,775 $54,469 $10,306 $ 847 First quarter decline in equity and receivables resulting from Raptor SPE amounting to $1 Billion (represents operating losses and further increases debt to equity problems) 7 3rd Quarter 10 Q - Debt comes home to roost Liquidity and Solvency Issues A downgrade below investment grade could lead to a substantial increase in the level of cash required for collateral and margin deposits with Enron's wholesale trading partners. Enron borrowed approx. $3 Billion from its committed line of credit. It used $1.1 Billion to retire debt coming due and $1.9 for liquidity. Enron announced plan to start selling off assets including global and broadband service segments. Enron disclosed that it has various financial arrangements that required Enron to maintain specified credit ratings. Absent posting significant collateral, this caused $690 Million to come due on demand on 11/27/01. Additional credit downgrade could cause $3.9 Billion to become due 9 mo. Net cash outflow from operations of $753 Million. 8 3rd Quarter 10 Q Profitability Issues Investment loses amounting to $716 Million Contingency: potential losses of $1.2 Billion associated with investment in power generation in India 9 $ Millions Assets Current Assets Cash and cash equivalents Trade receivables, net Other receivables Assets from price risk management activities Inventories Deposits Other receivables Total Current Assets 2000 1999 1998 $1,374 $10,396 $1,874 $12,018 $953 $2,433 $1,333 $30,381 $288 $3,030 $518 $2,205 $598 $81 $535 $7,255 $111 $2,060 $833 $1,904 $514 $$511 $5,933 $5,294 $8,988 $3,638 $5,459 $23,379 $5,036 $2,929 $2,799 $4,681 $15,445 $4,433 $1,941 $1,949 $4,437 $12,760 less accumulated depreciation Property, Plant and Equipment, net $6,916 $4,766 $839 $682 $2,256 $15,459 $3,716 $11,743 $6,948 $3,552 $379 $1,120 $1,913 $13,912 $3,231 $10,681 $6,936 $2,061 $989 $4,814 $992 $15,792 $5,135 $10,657 Total Assets $65,503 $33,381 $29,350 $9,777 $10,495 $1,679 $4,277 $2,178 $28,406 $2,154 $1,836 $1,001 $44 $1,724 $6,759 $2,380 $2,511 $$$1,216 $6,107 $8,550 $7,151 $7,357 $1,644 $9,423 $2,692 $13,759 $1,894 $2,990 $1,587 $6,471 $2,357 $1,421 $1,916 $5,694 Investments and Other Assets Investments in and advances to unconsolidated equity affiliates Assets from price risk management activities Goodwill Other Total investments and other assets Property, Plant and Equipment at cost Natural gas transmission Electric generation and distribution Fiber-optic network and equipment Construction in progress Other Liabilities and Shareholders' Equity Current Liabilities Accounts payable Liabilities from price risk management activities Short-term debt Customers' deposits Other Total Current Liabilities Long-term Debt Deferred Credits and Other Liabilities Deferred income Taxes Liabilities from price risk management activities Other Total Deferred Credits and Other Liabilities Minority Interest in Unconsolidated Subsidaries Company-Obligated Preferred Securities of Subsidiaries Shareholder's Equity Second preferrred stock Mandatorily Convertible Junior Preferred Stock Common Stock Retained Earnings Accumulated Other Comprehensive Income Common Stock Held in the Treasury Restricted Stock and Other Total Shareholder's Equity Total Liabilities and Shareholder's Equity Income Statement Revenues Natural gas and other products Electricity Metals Other Total Revenues Cost and Expenses Cost of gas, electricy metals and other products Operating expenses Depreciation, depletion and amortization Taxes, other than income taxes Impairment of long-lived assets Total costs and expenses Operating income $2,414 $2,430 $2,143 $904 $1,000 $1,001 $124 $1,000 $8,348 $3,226 $(1,048) $(32) $(148) $11,470 $130 $1,000 $6,637 $2,698 $(741) $(49) $(105) $9,570 $132 $$5,117 $2,226 $(162) $(195) $(70) $7,048 $65,503 $33,381 $29,350 $50,500 $33,823 $9,234 $7,232 $100,789 50.1% 33.6% 9.2% 7.2% 100.0% $19,536 $15,238 $$5,338 $40,112 48.7% 38.0% 0.0% 13.3% 100.0% $13,276 $13,939 $$4,045 $31,260 42.5% 44.6% 0.0% 12.9% 100.0% $94,517 $3,184 $855 $280 $$98,836 93.8% 3.2% 0.8% 0.3% 0.0% 98.1% $34,761 $3,045 $870 $193 $441 $39,310 86.7% 7.6% 2.2% 0.5% 1.1% 98.0% $26,381 $2,473 $827 $201 $$29,882 84.4% 7.9% 2.6% 0.6% 0.0% 95.6% 79% $802 2.0% 40% $1,378 4.4% 87% 21% 100% $309 $541 $$162 $181 $1,193 $1,995 0.8% 1.3% 0.0% 0.4% 0.5% 3.0% 5.0% 60% 100% $97 $56 $$88 $(37) $204 $1,582 0.3% 0.2% 0.0% 0.3% -0.1% 0.7% 5.1% 13% 100% $656 $76 $135 $104 $971 $1,024 $(131) $893 1.6% 0.2% 0.3% 0.3% 2.4% 2.6% -0.3% 2.2% $550 $77 $77 $175 $879 $703 $$703 1.8% 0.2% 0.2% 0.6% 2.8% 2.2% 0.0% 2.2% $1,953 1.9% Other income and deductions Equity in earnings of unconsolidated equity affiliates Gains on sales of non-merchant assets Gains on the issuance of stock by TNPC, Inc. Interest income Other income, net Total other income and deductions Income Before Interest, Minority Interests and Income Taxes $87 $146 $121 $212 $(37) $529 $2,482 0.1% 0.1% 0.1% 0.2% 0.0% 0.5% 2.5% Other Interest and related charges, net Dividends on company-obligated preferred securities of subsidiaries Minority interests in (earnings) losses of unconsolidated subsidaries Income tax expense Other charges Net income before cumulative effect of accounting changes Cumulative effect of accounting change, net of tax Net income $838 $77 $154 $434 $1,503 $979 $$979 0.8% 0.1% 0.2% 0.4% 1.5% 1.0% 0.0% 1.0% Cash Flow From Operating Activities Reconciliation of net income to net cash provided by operating activities Net income Cumulative effect of accounting chagnes Depreciation, depletion and amortization Impairment of long-lived assets (including equity investments) Deferred income taxes Gains on sales of non-merchant assets Changes in the components of working capital Net assets from price risk managemetn activities Merchant assets and investments Realized gains on sales Proceeds from sales Additions and unrealized gains Other operating activities Cash Flows from Investing Activities Capital expenditures Equity investments Proceeds from sales of non-merchant assets Acquisition of subsidiary stock Business acquisitions, net of cash acquired Other investing activities Net Cash Used in Investing Activities Cash Flows from Financing Activities Issuance of long-term debt Repayment of long-term debt Net incrase (decrease) in short-term borrowing Net issuance (redemption) of company obligated preferred securities of subsidiaries Issuance of common stock Issuance of subsidiary equity Dividends paid Net disposition of treasury stock Other financing activities Net Cash Provided by Financing Activities Increase (Decrease) in Cash and Cash Equivalents Cash and Cash Equivalents, Beginning of the Year Cash and Cash Equivalents, End of the Year $979 $$855 $326 $207 $(146) $1,769 $(763) $893 $131 $870 $441 $21 $(541) $(1,000) $(395) $703 $$827 $$87 $(82) $(233) $350 $(104) $1,838 $(1,295) $1,113 $4,779 $(756) $2,217 $(827) $174 $1,228 $(628) $1,434 $(721) $(97) $1,640 $(2,381) $(933) $494 $(485) $(777) $(182) $(4,264) $(2,363) $(722) $294 $$(311) $(405) $(3,507) $(1,905) $(1,659) $239 $(180) $(104) $(356) $(3,965) $3,994 $(2,337) $(1,595) $1,776 $(1,837) $1,565 $1,903 $(870) $(158) $(96) $307 $500 $(523) $327 $(6) $571 $$852 $568 $(467) $139 $(140) $2,456 $8 $867 $828 $(414) $13 $89 $2,266 $1,086 $288 $1,374 $177 $111 $288 $(59) $170 $111 Materiality Total Assets Total Revenues 2000 65,503,000,000 100,789,000,000 1999 33,381,000,000 40,112,000,000 Materiality Asset Based Revenue Based 28,805,930 39,865,690 18,848,110 20,934,720 30% 30% 56,950,986 29,906,743 Tax Rate Pre-tax Applying a Social Theory Structuration to Enron 1 Structuration in a Nutshell Anthony Giddens a social theorist is the originator Individuals are both constrained and enabled by communication , power and value structures within an organization The individual is therefore part of a dynamic that constructs and perpetuates the contexts within which ethical dilemmas arise and are resolved in organizations 2 Structuration : Primary Elements Agents & Structures Agents - individual actors or decision makers - Capable of analyzing their environment - Anticipating the consequences of their action and how it affects other agents and the organization - They are thoughtful and reflective but they are not immune to the strong structural forces working on them Agents are people - they understand the rules (culture) in which they operate - they adapt 3 Structures ,Cultures & Environment Formal and Informal Rules - There are at least as much informal than formal even if formal rules exist - People understand what the \"real rules\" are . They have applicable Materials and Managerial resources - Resources and rewards go to people who understand the \"real rules\" They - Enable and constrain - Provide guidance on how to interpret organizational phenomena and how to ascertain which activities are appropriate - Provide the power necessary to perform functions To survive and thrive you have to understand how things work 4 So how do you find out what the real rules are ? Structures of Legitimation - Walk Structures of Structuration - Talk Structures of Domination - Management Resources Walk , Talk and Support ( from the top) 5 Structures of legitimation Watch what people do ! Identify specific rights and obligations that give the agent a sense of which actions are legitimate Determine the positive and negative sanctions that will result from the actions of the agent \"illegitimate\" acts are legitimated by legitimation Examples: Organizational Politics , socialization processes , work routines, communication networks ,actual reward systems Nudge Nudge A nod is as good as a wink Know what I mean Gov ! 6 Structures of Signification Mostly Formal- watch what people say Rules that provide agents with ways to see and interpret events Provide Interpretive schemes that agents use to frame and understand their world Help agents attach meaning to their communication E.g. mission statement, management reports, training programs , performance evaluations You can usually find Signification written down 7 Structures of Domination What does the Power reward ? Resources that are mobilized by the agents to accomplish their objectives Can be Authoritative - agent has control over money or property Can be influential - the agent is admired or considered to be wise - is consulted in a crisis Examples: reward systems, organizational structures , decision power on resources ,the systems that are used by management Show me the money!! - Domination is nearly always about Resources (Time & Money) 8 Internalizing of Structures You are the system Agents have internalized the structures so draw upon them without necessarily recognizing that they are doing so The rules are shared by the organizational members and are difficult to resist or change Once internalized they seem natural or obvious and may not be open to question It's the way we do things around here 9 Reciprocal Relationship between Structures and Agents Structures Influence the action of agents They are continually reproduced through the actions of the agents When the actions of the agents are consistent with the structures then the structures are reinforced Acting inconsistently with the prevailing structures can transform them As in all life there are intended and unintended consequences so structures can be transformed in ways that cannot be anticipated . Things Change Over Time Systems Change People - People change Systems 10 Layzell's Theory of Walk & Talk An Organization where walk and talk differ is dysfunctional It is only a matter of time before it blows up If Talk and Walk differ then Walk wins It is only a matter of time what you do is more important than what you say ! They call it Domination for a reason Walk draws the money So Walk wins It is only a matter of time Stand back and examine your work, church , family any group and tell me that it is not so 11 So What has this got to do with Enron ? The Enron that went bust in December 2001 was not the same company that Ken Lay took over in 1985 or even the one that Jeff Skilling joined in It's Legitimation & Domination Structures had changed without the Signification Structures appearing to have changed When Walk does not equal talk then walk wins Layzell's maxim 12 Phases in the Life of Enron The regulatory phase - Houston Natural Gas The formative phase - Enron (1985-1996) - Enron is born (1985-1987) - A company, an industry, an economy in transition (1987-1991) - Calling the apostles and building the market oriented enterprise (1991-1996) The new company for the new economy (1996-2001) 13 The Regulatory Phase - Houston Natural Gas - Changes relatively slowly - Relatively risk adverse - Prices regulated based on cost structure - Operations not geared to react to market changes - Competition mediated - Growth constrained - Focus Controlling operations Influencing regulatory deliberations 14 Houston Natural Gas Legitimating Structures Tradition and rule following Financial conservatism Engineering expertise and scientific problems solving Political acumen within the regulatory arena Boring Boring Boring - don't you think ? Comfortable and Reliable maybe? Beauty is in the eye of the job applicant ! 15 The Formative Phase Moving towards Deregulation - Changes relatively quickly - Relatively risk seeking - Prices set by market - Operations geared to react to market ges - Competition - Growth - Focus Growth Maximizing shareholder value Deregulation - remember it is Reagan-Bush 41 -Clinton (Friedman-Von Hyack) 16 New Legitimating Structures Innovation and freedom to be creative Free markets foster healthy competition Competition yields ingenuity and dexterity External constraints are to be circumvented Formal control systems are inhibiting Market price represents a fair, unbiased measure of value Risk taking encouraged and accountability achieved through market Meritocracy Maximizing profits is synonymous with the social good Exciting eh !Don't these sound like good things to you ? Don't you wish you worked here ? It sounds like Intel to me !! 17 The New Company for the New Economy From Free Market to Free Marketeering I need a better phrase for free marketeering if anyone has one to offer I want to convey good free market vs bad free market 18 ENRON NEW ORGANIZATION FOR NEW ECONOMY 1997-2001 - Fortune - Most Innovative in America Leading Energy Company in North America August 2000 - Market Capitalization - $70 billion, Share price - $84/sh P/E 51/1(4x others) 2001 - Fortune - \"10 stocks to last a decade\" Bankruptcy - December 2001 Consumed $60 billion Cash 19 New Legitimating Structures Self indulgence and wastefulness Cut throat competition Cunning and ruthlessness where self interest rules License (e.g., accounting rules, ethical codes) Contempt of formal organization Speculation Social Darwinism Unquestioned performance criteria Instrumental rationality Hmm - this does not sound good What happened to the cool company I worked for ? why are those men putting handcuffs on me ? 20 So let's pretend for a moment that we are philosophers When does the line get crossed ? Little by Little From slide 17 to 20 21 Dialectical Consequences Innovation and freedom to be creative - Self indulgence and wastefulness Free markets foster healthy competition - Cut throat competition Competition yields ingenuity and dexterity - Cunning and ruthlessness where the ruthless aggression wins External constraints are to be circumvented - License to ignore law and custom (e.g., accounting rules, ethical codes) Formal control systems are inhibiting - Chaos from having no real control 22 Dialectical Consequences cont. Market price represents a fair, unbiased measure of value - Stifles search for additional criteria Informed Risk taking encouraged and accountability achieved through market - Unmanaged or monitored speculation Meritocracy - the best are rewarded - Social Darwinism - with an assumption that winning is one's natural right and no sympathy for the unfortunate Maximizing profits is synonymous with the social good - Manipulated Share Price becomes goal and excludes all other ends from consideration 23 So what is the Solution ? You are !! 24 Back Up 25 Regulatory Phase (pre - 1985) Old Culture Free Market Phase (1985-1997) New Culture Marketeering Phase (1997-2001) Mature Cultural Market structure Government regulated as a public utility Deregulation and free market structures implemented Free market structures established & dominant Scope of operations Natural gas distribution Legacy businesses, providing goods and services and trading Trading, deal making, commodity markets Dominant stakeholder group Regulators Shareholders, board of directors Capital markets, market analysts Overall objective Stability Growth World leader Pricing structure Cost based Commodity Market based Financial Market based Dominant discourse Engineering, operations, regulatory discourse Product and service market forces Financial market forces Growth potential Regulatory constraint Constrained by market size Unconstrained Management culture Rule following and tradition Production and market oriented Consulting mentality Level of autonomy High level of control Innovation and freedom to be entrepreneurial & creative Self interested behavior manifest as self indulgence and wastefulness Means of integration Technical cooperation yields tradition and rule following Healthy competition yields ingenuity and dexterity Cut throat warfare yields 26 cunning and ruthlessness where Risk attitude Risk averse Risk taking Speculation External constraints Provide the context for activity, restricting alternatives Are to be constructively overcome, eliminating barriers to progress Are to be disregarded leading to license Organizational control systems Strong, necessary and desirable, stability by maintaining the status quo Coupled with informal mechanisms, tolerated and inhibiting to change, providing balance Ineffectual, disregarded, fostering unbridled change leading to chaos Source of moral legitimacy Regulatory statutes Markets and legal requirements Financial markets Objective function Meet service demands within acceptable rate ranges Achieve acceptable financial performance levels Maximizing market capitalization Dominant discourse Operating costs and engineering expertise Market as fair and unbiased measure of value Market criteria to the exclusion of any other judgment criteria Accountability and control Achieved through formal control systems and regulatory oversight Achieved through markets and formal control mechanisms Achieved through market mechanisms exclusive of other factors Performance evaluation criteria Calculated results based on formal accounting and management systems Meritocracy based on market results within prescribed boundaries Social Darwinism based on market, leads to